One of the ways in which the US Federal Reserve has chosen to deal with the credit crisis is to increase inflation in the US. The series of interest rate cuts in the US are designed to lower the short-term cost of money for US banks. At the same time, the interest rate cuts weaken the dollar, make imports into the US more expensive and fan inflationary expectations.
All these factors together prevent long-term interest rates from coming down drastically, so the net result of the cuts in the Fed Funds rate has been a steeper yield curve — short-term rates have fallen more than long-term ones. That’s good for the banks, who borrow short and lend long. Over time, that will enable banks to make profits and recapitalize their balance sheets.
In short, the US Fed is trying to inflate its way out of the crisis. That, in a nutshell, is the view held by many experts in the field, including Satyajit Das, the authority on credit derivatives.
Unfortunately, while lower interest rates may be a solution to the problems of US banks, it seems to have become a scourge to the rest of the world, in particular to developing countries. That’s because lower real interest rates have led to a rapidly depreciating dollar. Since most of the world’s commodities are priced in US dollars, commodity prices have shot through the roof, as commodity producers try and shore up their purchasing power.
Consider just how rapidly the dollar has plunged. According to data from the New York Federal Reserve, the price-adjusted dollar index is now lower than at any time since the index was first compiled in 1973. According to this data, the index is now at 79.91, after falling to a record low of 78.99 last month.
In fact, the index has been declining ever since 2002 in fits and starts, but it had remained around 88 between May 2006 and June 2007. After that, there was a sudden sharp decline that took it down all the way to 78.99 in March 2008. The slide started around the time when the credit crisis first hit the US and speculation about rate cuts gathered momentum.
Now consider what happened to commodities. At the end of June last year, the Economist’s commodity price index was at 202.2, having risen by 15% in one year. On 18 March 2008 it was at 260.5, a rise of 29% in less than nine months. Simply put, while there’s no doubt that supply factors, such as the diversion of land for growing biofuels as well as increased demand for commodities from emerging markets has made a difference, it’s also true that the depreciating dollar has also had a potent impact.
Professor Jeffrey Frankel of Harvard University had, in a 2006 paper on “The Effect of Monetary Policy on Real Commodity Prices” pointed out that when real interest rates were high in the early 1980s, commodity prices had crashed. “A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories, and raising commodity prices, as happened during 2002-04. Call it part of the ‘carry trade’,” he wrote.
Other researchers have arrived at similar conclusions. Larry A. Sjaastad of the University of Chicago pointed out “that fluctuations of the US dollar strongly influence the prices of internationally traded goods was particularly evident during the intense real appreciation of the dollar from early 1980 until early 1985. During that period the dollar appreciated by more than 90% against the Deutsche Mark (and by 45% in real terms), while the IMF dollar-based commodity price index fell by 30%.”
However, that’s only half the story. A look at the inflation numbers of countries around the world show that among the worst hit are China, where consumer price inflation has gone up to 8.7% from 2.7% a year ago and Saudi Arabia, where it has risen from 3% to 8.7%. These are countries that peg their currencies tightly to the dollar. The Chinese government has desperately been trying to lower inflation but the real problem lies in the pegged currency, which keeps export prices low and results in a trade surplus. The surplus dollars are then bought by the Chinese central bank (with the result that it’s now sitting on a mountain of $1.5 trillion in foreign exchange reserves) while local currency is released, adding to money supply and pushing up prices.
In India, although the RBI (Reserve Bank of India) did let the rupee appreciate last year, which successfully kept inflation down, the rupee has been depreciating against the dollar more recently. In fact, it has even depreciated against the Chinese yuan—one yuan bought Rs5.4 on 1 January this year compared with Rs5.7 now. Since so much of Indian inflation is dependent on import prices, an easy way to control inflation would be to sell part of the RBI’s huge dollar hoard, which will lead to rupee appreciation.
Higher inflation has already started to squeeze margins and reduce earnings, seen clearly in Bhel’s (Bharat Heavy Electricals Ltd) recently announced results for the fourth quarter. It will also hurt the consumer, whose purchasing power will be eroded. And it will hit the bottom lines of sectors that are arm-twisted by the government in keeping prices down—such as steel, cement and oil companies while banks will be squeezed if the central bank tightens liquidity. In any case, with growth slowing down, the ability of companies to pass on price increases is limited. Small wonder the stock market is spooked.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at firstname.lastname@example.org.